# Regulatory Capital Rules: Regulatory Capital, Implementation of Tier 1/Tier 2 Framework > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2016-12072 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** July 28, 2016 - **Citation:** 81 FR 49720 ## Text FARM CREDIT ADMINISTRATION 12 CFR Parts 607, 611, 614, 615, 620, 624, 627 and 628 RIN 3052-AC81 Regulatory Capital Rules: Regulatory Capital, Implementation of Tier 1/Tier 2 Framework AGENCY: Farm Credit Administration. ACTION: Final rule. SUMMARY: The Farm Credit Administration (FCA or we) is adopting a final rule that revises our regulatory capital requirements for Farm Credit System (System) institutions to include tier 1 and tier 2 risk-based capital ratio requirements (replacing core surplus and total surplus requirements), a tier 1 leverage requirement (replacing a net collateral requirement for System banks), a capital conservation buffer and a leverage buffer, revised risk weightings, and additional public disclosure requirements. The revisions to the risk weightings include alternatives to the use of credit ratings, as required by section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act. DATES: Effective date: January 1, 2017. FOR FURTHER INFORMATION CONTACT: J.C. Floyd, Associate Director, Finance and Capital Markets Team, Timothy T. Nerdahl, Senior Policy Analyst—Capital Markets, or Jeremy R. Edelstein, Senior Policy Analyst, Office of Regulatory Policy, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4414, TTY (703) 883-4056; or Rebecca S. Orlich, Senior Counsel, or Jennifer A. Cohn, Senior Counsel, Office of General Counsel, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TTY (703) 883-4056. SUPPLEMENTARY INFORMATION: Table of Contents I. Introduction A. Objectives of the Final Rule B. Summary of the Proposed Rule C. Summary of the Final Rule D. Comments on the Proposed Rule E. Discussion of Threshold Issues Raised in the System Comment Letter 1. Basel III, the U.S. Rule, and Cooperative Principles 2. Treatment of Allocated Equities 3. Required Minimum Redemption/Revolvement Periods 4. Minimum Redemption/Revolvement Cycle for Association Investments in Their Funding Banks 5. Required Capitalization Bylaws Amendments Establishing Minimum Holding Periods 6. Higher Tier 1 Leverage Ratio and Minimum URE and URE Equivalents Requirement 7. Safe Harbor Requirement 8. Risk Weighting of Electric Cooperative Assets 9. Risk Weighting of High Volatility Commercial Real Estate Exposures 10. Unused Commitments To Fund Direct Loans II. Minimum Regulatory Capital Ratios, Additional Capital Requirements, and Overall Capital Adequacy A. Minimum Risk-Based Capital Ratios and Other Regulatory Capital Provisions B. Leverage Ratio C. Capital Conservation Buffer D. Supervisory Assessment of Overall Capital Adequacy III. Definition of Capital A. Capital Components and Eligibility Criteria for Regulatory Capital Instruments 1. Common Equity Tier 1 (CET1) Capital 2. Additional Tier 1 (AT1) Capital 3. Tier 2 Capital 4. FCA Approval of Capital Elements 5. FCA Prior Approval Requirements for Cash Patronage, Dividends, and Redemptions; Safe Harbor B. Regulatory Adjustments and Deductions 1. Regulatory Deductions From CET1 Capital a. Goodwill and Other Intangibles (Other Than Mortgage Servicing Assets) b. Gain-on-Sale Associated With a Securitization Exposure c. Defined Benefit Pension Fund Net Assets d. A System Institution's Allocated Equity Investment in Another System Institution e. Accumulated Other Comprehensive Income (AOCI) and Minority Interests f. Discretionary “Haircut” Deduction or Other FCA Supervisory Action for Redemption of Equities Included in CET1 Capital Less Than 7 Years After Issuance or Allocation 2. The Corresponding Deduction Approach for Purchased Equities 3. Netting of Deferred Tax Liabilities Against Deferred Tax Assets and Other Deductible Assets C. Limits on Inclusion of Third-Party Capital IV. Standardized Approach for Risk Weighted Assets A. Calculation of Standardized Total Risk Weighted Assets B. Risk Weighted Assets for General Credit Risk 1. Exposures to Sovereigns 2. Exposures to Certain Supranational Entities and Multilateral Development Banks 3. Exposures to Government-Sponsored Enterprises 4. Exposures to Depository Institutions, Foreign Banks, and Credit Unions 5. Exposures to Public Sector Entities 6. Corporate Exposures 7. Residential Mortgage Exposures 8. High Volatility Commercial Real Estate Exposures 9. Past Due and Nonaccrual Exposures 10. Other Assets 11. Exposures to Other System Institutions 12. Specialized Exposures C. Off-Balance Sheet Items 1. Credit Conversion Factors (CCF) 2. Credit-Enhancing Representations and Warranties D. Over-the-Counter Derivative Contracts E. Cleared Transactions F. Credit Risk Mitigation G. Unsettled Transactions H. Risk Weighted Assets for Securitization Exposures I. Equity Exposures V. Market Discipline and Disclosure Requirements VI. Conforming and Clarifying Changes VII. Timeframe for Implementation VIII. Abbreviations IX. Regulatory Flexibility Act Addendum: Discussion of the Final Rule I. Introduction A. Objectives of the Final Rule The FCA's objectives in adopting this final rule are: • To modernize capital requirements while ensuring that institutions continue to hold enough regulatory capital to fulfill their mission as a Government-sponsored enterprise (GSE); • To ensure that the System's capital requirements are comparable to the Basel III framework and the standardized approach that the Federal banking regulatory agencies have adopted, but also to ensure that the rules take into account the cooperative structure and the organization of the System; • To make System regulatory capital requirements more transparent; and • To meet the requirements of section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). B. Summary of the Proposed Rule On September 4, 2014, the FCA published in the Federal Register a notice of proposed rulemaking seeking public comment on revisions to our regulatory capital requirements governing System banks, 1 System associations, the Farm Credit Leasing Services Corporation, and any other FCA-chartered institution the FCA determines should be subject to this rule (collectively, System institutions). 2 The proposed rule, where appropriate, was comparable to the capital rules published in October 2013 and April 2014 by the Federal banking regulatory agencies 3 for the banking organizations they regulate (U.S. rule). 4 Those rules follow the Basel Committee on Banking Supervision's (BCBS or Basel Committee) document entitled “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (Basel III), including subsequent changes to the BCBS's capital standards and BCBS consultative papers, and our proposed rule followed Basel III as appropriate for cooperatives. 5 1 For purposes of this preamble and part 628, as well as some of the regulations in which there are conforming changes and other existing regulations, the term “System bank” includes Farm Credit Banks, agricultural credit banks, and banks for cooperatives. It has the same meaning as “Farm Credit bank”, which is defined in § 619.9140 and will continue to be used in some of the regulations in which there are conforming changes as well as in other existing regulations. The Farm Credit Act of 1971, as amended (Farm Credit Act or Act), uses the term “System bank” in a number of its provisions. 2 79 FR 52814 (September 4, 2014). 3 The Federal banking regulatory agencies are the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), and the Federal Deposit Insurance Corporation (FDIC). 4 78 FR 62018 (October 11, 2013) (final rule of the OCC and the FRB); 79 FR 20754 (April 14, 2014) (final rule of the FDIC). 5 Basel III was published in December 2010 and revised in June 2011. The text is available at http://www.bis.org/publ/bcbs189.htm . The BCBS was established in 1974 by central banks with bank supervisory authorities in major industrial countries. The BCBS develops banking guidelines and recommends them for adoption by member countries and others. BCBS documents are available at http://www.bis.org . The FCA does not have representation on the Basel Committee, as do the Federal banking regulatory agencies, and is not required by law to follow the Basel standards. The proposed rule was intended to: • Improve the quality and quantity of System institutions' capital and enhance risk sensitivity in calculating risk weighted assets, • Provide a more transparent picture of System institutions' capital to the investment-banking sector, which could facilitate System institutions' securities offerings to third-party investors, and • Comply with section 939A of the Dodd-Frank Act 6 by proposing alternatives to credit ratings for calculating risk weighted assets for certain exposures that are currently based on the ratings of nationally recognized statistical rating organizations (NRSROs). 6 Public Law 111-203, 124 Stat. 1376 (2010). After the worldwide financial crisis that began in 2008, the BCBS issued the Basel III framework and has continued to issue additional standards, with the goal of strengthening financial organizations' capital. The U.S. rule reflects Basel III as well as aspects of Basel II and other BCBS standards. The provisions of the U.S. rule that are not specifically included in the Basel III framework are generally consistent with the goals of the framework. The FCA's proposed rule was comparable to the standardized approach rules of the Federal banking regulatory agencies to the extent appropriate for the System's cooperative structure and status as a GSE with a mission to provide a dependable source of credit and related services for agriculture and rural America. Consistent with the U.S. rule, the FCA's proposed rule incorporated key aspects of the Basel III tier 1 and tier 2 framework and included the following minimum risk-based ratios: • CET1 capital of 4.5 percent; • Tier 1 capital of 6 percent; and • Total capital of 8 percent. The risk-based minimum ratios are identical to the ratios in the U.S. rule. In contrast to Basel III and the U.S. rule, we did not include all accumulated other comprehensive income (loss) (AOCI) in CET1. We note, however, that under the final U.S. rule, qualifying commercial banks can elect to opt-out of including AOCI in their regulatory capital ratios. We also proposed a tier 1 leverage ratio of 5 percent, of which at least 1.5 percent must be unallocated retained earnings (URE) and URE equivalents (nonqualified allocated surplus that is never revolved). Our proposal differed from the U.S. rule's minimum tier 1 leverage ratio of 4 percent with no minimum URE requirement. We proposed a capital conservation buffer of 2.5 percent to enhance the resilience of System institutions, the same capital conservation buffer as in the U.S. rule. Our proposed capital conservation buffer similarly had a phase-in period of 3 years, but we did not propose to incorporate any of the other transition periods in Basel III and the U.S. rule. The proposed rule imposed some new patronage refund and equity redemption requirements, including FCA prior approvals, on System institutions to provide comparability with the U.S. rule and also to ensure the stability and permanence of the capital includable in the tier 1 and tier 2 capital ratios. We proposed that System institutions must retain equities included in CET1 capital for at least 10 years and retain equities included in tier 2 capital for at least 5 years, unless the FCA grants prior approval to redeem or revolve at an earlier date. We proposed to require institutions to adopt a bylaw committing the institutions to the minimum redemption and revolvement periods. We provided a “safe harbor,” or deemed prior approval, for cash patronage refund payments and equity redemptions and revolvements as long as the dollar amount of the institution's CET1 capital was equal to or above the dollar amount of the institution's CET1 on the same date of the previous year. Both the Basel III framework and the U.S. rule and applicable law have similar prior approval requirements, but we adapted these requirements to the System's cooperative structure and operations. The proposed rule contained regulatory deductions and adjustments in the capital ratio calculations that are comparable in purpose to those required in Basel III and the U.S. rule. However, we modified the deductions and adjustments in consideration of the two-tiered, financially interdependent, cooperative structure of the System. We proposed to require deductions from CET1 of goodwill and other intangibles and of allocated equity investments in other System institutions, service corporations, and the Funding Corporation. We also proposed to require System institutions that have purchased equity investments in other System institutions to deduct the investment using the corresponding deduction approach. A “haircut” deduction of a portion of allocated equities was required if an institution redeemed or revolved equities before the end of the applicable minimum redemption or revolvement period. We proposed a limit on how much third-party capital—capital held by investors other than other System institutions or their member-borrowers—could count in the regulatory capital ratios. The proposed limit was similar to the limit the FCA had previously imposed on System institutions on a case-by-case basis. The FCA also proposed changes to its risk-based capital rules for determining risk weighted assets—that is, the calculation of the denominator of a System institution's risk-based capital ratios. We proposed to eliminate the credit ratings of NRSROs from risk weights for certain exposures, consistent with section 939A of the Dodd-Frank Act. As an alternative, FCA proposed to include methodologies for determining risk weighted assets for exposures to sovereigns, foreign banks, and public sector entities, securitization exposures, and counterparty credit risk. We proposed an increased risk-weight for high-volatility commercial real estate (HVCRE) exposures and for past due and nonaccrual exposures. We did not propose to alter FCA Bookletter BL-053, which since 2007 has permitted lower risk weights for certain exposures to generation and transmission and electric distribution cooperatives (electric cooperatives), but we also did not propose to include the lower risk weights in the rule. We proposed to increase the credit conversion factors (CCF) that apply to unused commitments, including commitments from System banks to associations to fund direct loans. We proposed to eliminate the existing 50-percent risk weight for certain other financing institutions (OFIs). We proposed certain due diligence requirements in connection with securitization exposures. The proposed rule included new risk weights for cleared transactions, guarantees including credit derivatives, collateralized financial transactions, unsettled transactions, and securitization exposures. We generally did not propose risk weightings for exposures that System institutions have no authority to acquire. 7 In some but not all cases, we discussed in the preamble this variance from the rules of the Federal banking regulatory agencies. In addition, we did not propose risk weightings for certain exposures that are both complex and unlikely; we stated that we would determine the treatment on a case-by-case basis using our regulatory reservation of authority. We generally discussed these exposures in the preamble. We reminded System institutions that the presence of a particular risk weighting does not itself provide authority for a System institution to have an exposure to that asset or item. System authorities to acquire exposures are contained in other provisions of our regulations and in the Farm Credit Act. 7 However, we did propose risk weighting for exposures that System institutions are not permitted to acquire under their investment authorities, because such exposures could be acquired through foreclosures on collateral or similar transactions. We did not propose to adopt the “advanced approaches” regulatory capital rules because no System institution has the volume of assets or foreign exposures that would subject it to those approaches if it were regulated by a Federal banking regulatory agency. 8 We also did not propose the market risk requirements, because no System institution has significant exposure to market risk. 8 In general, the advanced approaches rule applies to banks with consolidated total assets of at least $250 billion or with foreign exposures of $10 billion or more. Only two System institutions have total assets in excess of $50 billion, and foreign exposures are negligible. The proposed rule also required additional recordkeeping and disclosures by System banks, comparable to the required disclosures in the U.S. rule for commercial banks with assets of $50 billion and above. It was our belief that the benefits to the System of these proposed rules would more than outweigh the requirements and additional responsibilities we would require. We proposed to: (1) Place the tier 1 and tier 2 risk weighted and leverage capital requirements in a new part 628 of FCA regulations in title 12 of the Code of Federal Regulations: (2) rescind the risk-weighting provisions in subpart H of part 615 and the core surplus, total surplus, and net collateral requirements in subpart K of part 615; (3) retain in part 615 the requirements for the numerator of the permanent capital ratio, a measure that is mandated by the Farm Credit Act, but make the risk weightings for the denominator of the permanent capital ratio the risk weightings in new part 628; and (4) make conforming changes in other FCA regulations. In the proposed rule, we used the general format and the section and paragraph numbering system of the U.S. rule to the extent possible. In many cases, we retained the numbering system by reserving sections and paragraphs where we did not propose parallel provisions. We did so in order to facilitate the comparison of the proposal with the U.S. rules. C. Summary of the Final Rule The final rule replaces the FCA's core surplus, total surplus, and net collateral rules with common equity tier 1 (CET1), tier 1, total capital, capital conservation buffer, and leverage buffer rules as described below. The final rule also revises the risk weightings in the existing rule and makes minor adjustments to the permanent capital calculation. In addition, it expands public disclosure requirements for System banks. After considering the comments we received, we have made changes in the final rule to address policy, technical, and compliance concerns raised by commenters. In the final rule, we have adopted the minimum CET1, tier 1, and total risk-based capital ratios as set forth in the proposed rule. We have adopted a lower tier 1 leverage ratio of 4 percent in the final rule but have retained the URE and URE equivalents requirement of 1.5 percent, and we have added a tier 1 leverage buffer of 1 percent. We have adopted the capital conservation buffer of 2.5 percent as proposed and have provided a phase-in period of 3 years that will end on December 31, 2019. We have revised a number of the proposed patronage refund and equity redemption or revolvement requirements: • We have revised the minimum CET1 redemption or revolvement period to 7 years from 10 years in the proposal but have adopted the other minimum periods as proposed. • We have provided that institution boards may adopt a resolution annually that commits the institutions to comply with the minimum redemption and revolvement periods, as an alternative to adopting a capital bylaw. • We have expanded the “safe harbor” to exempt 3 types of equity redemptions or revolvements from the applicable minimum holding periods: (1) Equities mandated to be redeemed or retired by a final order of a court of competent jurisdiction; (2) equities belonging to the estate of a deceased former borrower; and (3) equities that the institution is required to cancel under § 615.5290 of our regulations. We have adopted the regulatory deductions and adjustments in the final rule as proposed, with several exceptions. We have revised the 30-percent mandatory “haircut” for noncompliance with the minimum revolvement periods and have replaced it with a provision stating that the FCA may take a supervisory or enforcement action for noncompliance with the minimum revolvement periods, which may include requiring an institution to deduct a portion of its equities from CET1 capital. We have simplified the calculation for the third-party capital limit. We have not finalized the proposed provisions governing HVCRE at this time. We have not included lower risk weights for exposures to electric cooperatives in the rule, but FCA Bookletter BL-053 remains in effect. We have applied a 20-percent CCF to all unused commitments from System banks to fund direct loans without regard to maturity, rather than applying a 50-percent CCF to commitments longer than 14 months, and we have clarified that this capital treatment applies to direct loan commitments to OFIs as well as associations. We have retained the existing, but not proposed, 50-percent risk weight for loans to certain OFIs, but we have eliminated the credit rating standard for this risk weight. We have retained the higher risk weight for past due and nonaccrual exposures and the due diligence requirements for securitization exposures. We have revised the definition of Government-sponsored enterprise (GSE) to include the System. We have adopted the recordkeeping disclosure requirements for System banks as proposed. We have adopted conforming changes to existing FCA regulations. Table 1—Summary of Key Provisions of the Tier 1/Tier 2 Capital Items and Standardized Approach Risk Weights Minimum capital ratios Treatment in final rule Tier 1/Tier 2—Capital Items Common equity tier 1 (CET1) capital ratio (§ 628.10) A minimum requirement of 4.5 percent. Tier 1 capital ratio (§ 628.10) A minimum requirement of 6.0 percent. Total capital ratio (§ 628.10) A minimum requirement of 8.0 percent. Tier 1 Leverage ratio (§ 628.10) A minimum tier 1 leverage ratio requirement of 4.0 percent of which at least 1.5 percent must consist of unallocated retained earnings and unallocated retained earnings equivalents. Applies to all System institutions. Components of Capital and Eligibility Criteria for Regulatory Capital Instruments (§§ 628.20, 628.21, and 628.22) Describes the eligibility criteria for regulatory capital instruments and adds certain adjustments to and deductions from regulatory capital. Capital Conservation Buffer and Leverage Buffer Amounts (§ 628.11) A 2.5-percent capital conservation buffer of CET1 capital above the minimum risk-based capital requirements and a 1-percent leverage buffer of tier 1 capital above the minimum capital requirement, both of which must be maintained to avoid restrictions on capital distributions and certain discretionary bonus payments. Risk weighted Assets—Standardized Approach Credit exposures to: Remains unchanged from existing regulations: U.S. government and its agencies 0 percent. U.S. depository institutions and credit unions (including those that are OFIs) 20 percent. U.S. public sector entities, such as states and municipalities 20 percent—general obligations. Cash 50 percent—revenue obligations. Cash items in the process of collection 0 percent. Exposures to other System institutions that are not deducted from capital 20 percent. Assets not specifically assigned to a risk weight category and not deducted from capital 100 percent. (§ 628.32) 100 percent. Exposures to certain supranational entities and multilateral development banks (§ 628.32) Assigned a 0 percent risk weight (reduced from 20 percent). Exposures to Government-sponsored enterprises (§ 628.32) Non-System exposures: Risk weight for preferred stock increased from 20 percent to 100 percent. Risk weight for all other exposures (except equity exposures, which are discussed below) remains at 20 percent. System exposures: Risk weight for direct loans remains at 20 percent. All equities, including preferred stock, deducted from capital (not risk weighted). Credit exposures to: Foreign sovereigns; Foreign banks; Foreign public sector entities (§ 628.32) Assigns risk-sensitive risk weights based on the Country Risk Classification measure produced by the Organization for Economic Cooperation and Development (risk weight no longer determined based on OECD membership status). Corporate exposures (§ 628.32) Assigns a 100-percent risk weight to most corporate exposures, including exposures to agricultural borrowers and to OFIs that do not satisfy the criteria for a 20-percent or 50-percent risk weight. Assigns a 50-percent risk weight to non-depository institution/non-credit union OFIs that are investment grade or that meet standards similar to OFIs that qualify for a 20-percent risk weight. Residential mortgage exposures (§ 628.32) 50 percent for first lien residential mortgage exposures that satisfy specified underwriting criteria. 100 percent otherwise. High volatility commercial real estate exposures (§ 628.32) Provisions assigning higher risk weight not adopted in this rulemaking. Additional rulemaking or guidance may take place in future. Past due and nonaccrual exposures (§ 628.32) Assigns a 150-percent risk weight to exposures that are past due or in nonaccrual status, unless they are residential mortgage exposures or they are guaranteed or secured by financial collateral. Off-balance Sheet Items (§ 628.33) Certain credit conversion factors (CCF) revised, including the CCF for unused short-term commitments that are not unconditionally cancellable, which is increased from 0 percent to 20 percent. OTC Derivative Contracts (does not include cleared transactions) (§ 628.34) Modifies derivative matrix table slightly. Recognizes credit risk mitigation of collateralized OTC derivative contracts. Cleared Transactions (§ 628.35) Provides preferential capital requirements for cleared derivative and repo-style transactions (as compared to requirements for non-cleared transactions) with central counterparties that meet specified standards. Guarantees and Credit Derivatives (§ 628.36) Provides a more comprehensive recognition of guarantees. Collateralized Transactions (§ 628.37) Recognizes financial collateral. Unsettled Transactions (§ 628.38) Risk weight depends on number of business days past settlement date. Securitization Exposures (§§ 628.41, 628.42, 628.43, 628.44, and 628.45) Replaces the ratings-based approach with either the standardized supervisory formula approach (SSFA) or the gross-up approach for determining a securitization exposure's risk weight based on the underlying assets and exposure's relative position in the securitization's structure. Equity exposures (§§ 628.51, 628.52, and 628.53) Establishes a more risk-sensitive treatment for equity exposures. Disclosure Requirements (§§ 628.61, 628.62, and 628.63) Establishes qualitative and quantitative disclosure requirements, including regarding regulatory capital instruments, for all System banks. Existing FCA Regulatory Capital Minimum Capital Ratios: Permanent capital ratio (§§ 615.5201 and 615.5205) Numerator calculation remains unchanged, but risk weights (denominator) are revised. Total surplus ratio (§§ 615.5301(i) and 615.5330(a)) Eliminated. Core surplus ratio (§§ 615.5301(b) and 615.5330(b)) Eliminated. Net collateral Ratio (banks only) (§§ 615.5301(d) and 615.5335) Eliminated. D. Comments on the Proposed Rule The original comment period for the proposed rule was for 120 days, ending on January 2, 2015. At the request of the System, on December 23, 2014, the FCA extended the comment period to February 16, 2015, 9 and on June 23, 2015 the FCA reopened the comment period for a 15-day period between June 26 and July 10, 2015. 10 9 See 79 FR 76927 (December 23, 2014). 10 See 80 FR 35888 (June 23, 2015). The Farm Credit Council stated that the reason for the System's request was to give System representatives the opportunity to discuss the proposed rule with the FCA Board members that had joined the FCA Board on March 13 and 17, 2015. The FCA received approximately 2400 public comments on the proposed rule. Nearly 500 of the comments were from individual System associations and their directors and officers; the 4 System banks; and the Farm Credit Council, a trade association representing the interests of System institutions. Approximately 1800 member-borrowers of one System association submitted comments. 11 We also received a comment letter from a member of Congress on behalf of several of his constituents. The comment letter submitted by the Farm Credit Council (System Comment Letter) states that the System's capital workgroup developed the comments after soliciting input from all System institutions. This input was further discussed and reviewed among the institutions, after which the capital workgroup circulated a draft comment letter for further review. 12 The System Comment Letter is comprehensive and detailed, covering most or all of the numerous regulatory philosophy, policy and technical issues directly and indirectly addressed in the proposed rule. Because the System Comment Letter was developed with input of all System institutions, the FCA focuses primarily on addressing those comments in this preamble. The preamble also addresses the individual comment letters of System institutions and their members and representatives, as well as those of non-System commenters, that contain substantially different arguments or discuss other issues. 11 The great majority of the comments were the same form letter; however, a number of these commenters added hand-written comments to the form letter. 12 A number of the comment letters from individual System institutions summarized, were identical to, or closely tracked, the System Comment Letter. In addition, 3 comments were from non-System agricultural lenders with lending relationships with System banks (other financing institutions or OFIs). Approximately 70 rural electric cooperatives and a trade association representing rural electric cooperatives submitted comments. Each of these two groups of commenters submitted a comment regarding the single issue of the proposed risk-weightings of System institutions' exposures to their particular business. We also received comments from several educational and trade associations promoting the interests of farmers and farm businesses, cooperative businesses, rural electric cooperatives, and U.S. community bankers. The farm-related and cooperative trade associations all submitted a general comment supporting the System Comment Letter. They urged the FCA not to adopt regulations that would diminish the democratic nature of cooperatives, their unique governance structure, and their ability to maintain financial and ethical integrity. The trade association representing community banks expressed concern about some provisions of the U.S. rule as applied to community banks and generally recommended the imposition of more strenuous capital requirements on System institutions. The trade association asserted that 1) there was an implicit government guarantee of the debt and equity of System institutions that the Basel III framework and the proposed rule failed to address, and that 2) this failure put taxpayers at risk for future bailouts, while privately-funded and well-capitalized community banks suffer with higher funding costs and absence of a government backstop. These trade association letters did not include comments on specific aspects or requirements of the proposed rule. E. Discussion of Threshold Issues Raised in the System Comment Letter This section of the preamble addresses the issues that the System Comment Letter identified as “Threshold Issues.” 1. Basel III, the U.S. Rule, and Cooperative Principles The System Comment Letter expressed strong support for modernizing the FCA's capital regulations through the adoption of a tiered framework comparable to Basel III and the U.S. rule. The System stated that such a modernization “will be helpful to external investors and others who are acquainted with the Basel III framework and understand the overall financial strength and capital capacity of individual [System] institutions as cooperative financial institutions.” The System asserted, however, that the FCA's proposed rule is “far harsher” and, in addition, “discourages the formation, retention, and distribution of member-held equity, undermining cooperative business principles that have been in place for decades.” The System further asserted that, “[a]s expected by Basel III, FCA should take into account all principles specific to the constitution and legal structure of cooperatives.” The System Comment Letter is divided into three parts. The first part discusses 9 “threshold” issues important to the System, including a number identified as “undermin[ing] cooperative principles and member participation in the management, ownership, and control of System institutions as required by the Act.” The second part, Appendix A, contains comments to specific questions we asked in the preamble to the proposed rule. The third part, Appendix B, identifies “various conceptual and technical issues” that are explained in a discussion of particular aspects of the regulation text. We first address the general assertion that the proposed rule is anti-cooperative as well as the issues identified in the System Comment Letter as “threshold issues.” The section that follows discusses the System's remaining comments and other comments that we received. In proposing the capital rule, it was our intention to implement capital requirements that are comparable to the Basel III framework as embodied in the U.S. rule, with adjustments to take into consideration the structure and operations of System institutions. As the System Comment Letter notes, the Basel III framework's capital components are described by the Basel Committee in terms of the capital of joint-stock banks—that is, financial institutions that issue stock to investors whose objective is to earn a profit. (We note that System institutions, like some other cooperative financial institutions, do issue stock, but they are not joint-stock banks as that term is used by the Basel Committee.) Investors with voting interests in a joint-stock bank are not required to do business with the joint-stock bank in which they own stock, and there is no connection between their ownership interests and any customer relationship they may have with such bank. Cooperatives and mutual associations, unlike joint-stock banks, are not created for the profit of investors but rather for the benefit of their member-borrowers, and there is a close connection between their equity ownership and their customer relationship with the cooperative institution or mutual. The Basel Committee intended the criteria for joint-stock banks also to apply to other banking organizations, as explained in footnote 12 to the Basel III document: The criteria also apply to non-joint stock companies, such as mutuals, cooperatives or savings institutions, taking into account their specific constitution and legal structure. The application of the criteria should preserve the quality of the instruments by requiring that they are deemed fully equivalent to common shares in terms of their capital quality as regards loss absorption and do not possess features which could cause the condition of the bank to be weakened as a going concern during periods of market stress. Supervisors will exchange information on how they apply the criteria to non-joint stock companies in order to ensure consistent implementation. The System Comment Letter appears to interpret this footnote to mean that Basel III-based regulations for cooperatives, such as the FCA's proposed rule, must take account of the “specific constitution and legal structure” of System institutions by deferring to “all cooperative principles” that are inconsistent with the Basel III criteria for joint-stock banks. Such an interpretation is not entirely without basis, given the lack of detail in the footnote, and this may have already have led to greater flexibility than intended by the Basel Committee in some banking agencies' regulatory interpretations. We note that, in December 2014, banking experts appointed by the Basel Committee to assess whether European Union pronouncements and its member countries' regulations comply with the Basel III framework raised concerns about exceptions some countries made to the framework for mutually owned institutions and suggested the Basel Committee consider issuing more specific guidance. 13 The Basel framework provides some clarity in a discussion of strengthening the global capital framework, in which the Basel Committee emphasizes the need for uniform standards for regulatory capital: 13 See Basel Committee on Banking Supervision, “Regulatory Consistency Assessment Program (RCAP): Assessment of Basel III regulations—European Union,” December 2014. Paragraph 1.4.3 states the following, in pertinent part: CET1 instruments issued by mutually owned institutions: Basel III permits some flexibility in order to accommodate the nature of capital instruments of different mutually owned banks. However, the Assessment Team is concerned that the CRR concessions from the 14 CET1 criteria for mutuals go beyond the permissible flexibility in the Basel standard, while noting that this standard does not precisely define the extent of permissible flexibility. This is an area where the BCBS could provide additional guidance on the extent of flexibility considered appropriate for CET1 issued in mutual bank structures. In the case of one banking group, the Assessment Team observed that individual instruments of some cooperative banks were being marketed as being redeemable, non-loss absorbing in liquidation, and paying a distribution based on the face value. In the Assessment Team's view, this goes beyond the limits of permissible flexibility in Basel III. The fact that regulatory approval is required for redemption and that redemption may be deferred does not, in the team's opinion, mitigate the public perception that these instruments are redeemable, despite the approval requirements set out in the CRR. While the amount of such instruments is clearly material for banks with mutual structures, the Assessment Team understands that these are well understood capital structures supported by Member State law that have proven resilient in times of stress. Moreover, some of the internationally active parts of such banking groups are capitalised by common equity in the form of publicly listed ordinary shares, which serves as an alternative source of loss-absorbing capital. This is an area where the Assessment Team believes the Basel Committee could provide additional guidance on the extent of flexibility considered appropriate for CET1 issued in mutual bank structures. As a result, this issue is noted as a deviation, but the Assessment Team has not factored this element into the grade for the definition of capital category nor into the overall assessment grade. The crisis . . . revealed the inconsistency in the definition of capital across jurisdictions and the lack of disclosure that would have enabled the market to fully assess and compare the quality of capital between institutions. To this end, the predominant form of Tier 1 capital must be common shares and retained earnings. This standard is reinforced through a set of principles that also can be tailored to the context of non-joint stock companies to ensure they hold comparable levels of high quality Tier 1 capital. Deductions from capital and prudential filters have been harmonized internationally and generally applied at the level of common equity or its equivalent in the case of non-joint stock companies. 14 14 Basel III Framework, paragraphs 8 and 9. The FCA disagrees with the apparent interpretation in the System Comment Letter that the Basel III footnote 12 directs regulators to defer to mutual and cooperative constitutions and legal structures. There are 4 key points in the footnote, as clarified by the discussion in the text of the framework document, that we followed in the proposed rule. First, cooperative capital 15 that is included in CET1 or tier 2 capital must be substantively equivalent in quality to the CET1 or tier 2 capital of joint-stock banks, and that means cooperative capital must be excluded if they are not substantively equivalent. Second, cooperative capital must be excluded if it has features (including features that may be typical of cooperative operations) that weaken the capacity of the institution to continue operations during stressful times. Third, exceptions and adjustments to the criteria are in some cases necessary because of cooperative institutions' legal authorities and mandates, in order to ensure the uniform quality of the components and consistent implementation of the standards. Fourth, consistent implementation of the standards is required to enable the market to compare the quality of capital between institutions. Otherwise, the framework's goal of uniform capital standards among financial institutions would not be achieved—and the FCA could not represent our rule as comparable to Basel III and the U.S. rule. Not being able to represent our rule as comparable would eliminate a primary reason given by the System to modernize the capital regulations—to help third-party investors that are acquainted with the Basel III framework evaluate System institutions' capital. 15 Cooperative capital includes common cooperative equities and preferred stock issued to member-borrowers or other System institutions. In the proposed rule we made appropriate exceptions and adjustments related to legal authorities, structure and also traditional operations that are cooperative in nature. These include the exception for the liquidation priorities of URE and common cooperative equities; the eligibility requirements to become member-borrowers; the requirement to purchase member stock in order to obtain a loan; the restriction of association voting rights to member-borrowers in agriculture and related businesses and the restriction of bank voting rights to member associations and retail cooperative member-borrowers; the one-member, one-vote mandate for association member-borrowers; and the proportional voting mandate for associations and cooperatives that borrow from System banks. An important difference from joint-stock corporations such as commercial banks is that the voting stockholders, because they are also the customers, want both low interest rates on their loans and high amounts of patronage payments, and they are in a position to pressure the institution to provide patronage payments on a regular basis. Some institutions encourage member expectations by promoting and illustrating patronage payments as a routine “cash-back dividend” that effectively reduces the real interest rate on a member's loan as demonstrated by materials on their Web sites and in press releases. Our proposed rule also included exceptions and adjustments to take into account non-cooperative differences between System institutions and commercial banks in legal authorities, mandates, and legal structure. Such differences include: (1) The two-tiered structure of System banks supervising and lending to the System associations that own them; (2) the joint and several liability of System banks for almost all the general debt they issue; (3) the GSE status of the System; (4) the limitations on System associations to borrow from financial institutions other than their affiliated System bank; (5) the statutory discretion of a System institution to redeem purchased stock and retire allocated equities; and (6) the requirement that System institution voting members must approve amendments to the capitalization bylaws. Commercial banks have capital-related restrictions, some statutory and some in the U.S. rule, that the Act and our regulations have not previously imposed on System institutions, such as: (1) Restrictions on redemption of equities without both regulatory approval and stockholder approval; (2) restrictions on cash dividend payments without regulatory approval; and (3) prompt corrective action. Restrictions and adjustments in our capital rule, to the extent consistent with the System's GSE status, are also necessary in order to make our regulatory capital framework substantively comparable to the U.S. rule. We note that the U.S. rule does not have specific provisions for mutual banking organizations. 16 The regulatory capital of these mutuals is made up almost entirely of retained earnings that we understand are never allocated to members; consequently, the retained earnings of mutuals have the same characteristics as the retained earnings of joint-stock banks—and, in our judgment, the URE of System institutions. Because neither joint-stock banks nor mutuals allocate equities, the U.S. rule does not take into consideration the allocation process. 17 In most cases, once a System institution has allocated equities to members, the members acquire ownership attributes that make the earnings stock-like and more appropriately treated like stock than like URE. The distinction is important because, if we treated allocated equities the same way we treat URE, none of the criteria that apply to equities included in tier 1 and tier 2 capital—including minimum revolvement periods and the expectation criterion discussed below—would apply. 16 The OCC issued a bulletin in 2014 describing the characteristics of mutuals and discussing supervisory considerations, including capital issues. See http://www.occ.gov/news-issuances/bulletins/2014/bulletin-2014-35.html . The OCC's decision not to adopt special provisions for mutuals appears to be due to the fact that the legal authorities do not differ between commercial banks and mutuals in ways that require adjustments to the rule. According to the bulletin, mutual associations are subject to the same laws and regulations as joint-stock banks except for regulations on chartering, bylaws, combinations, and member communications. 17 When a System institution pays patronage in the form of equities and retains these equities for the benefit of the cooperative institution, this is known as the allocation process in which a member-borrower's name is assigned to those equities. 2. Treatment of Allocated Equities The System Comment Letter states that allocated equities are retained earnings and uses the term “allocated retained earnings” throughout its comment, stating that “allocated retained earnings” are the same as URE and should be treated the same way. The System makes a number of additional assertions about Basel III and the U.S. rule. These assertions include: • Basel III does not establish tiers of retained earnings, does not require deduction from retained earnings of amounts that a commercial bank has announced it plans to distribute, and does not exclude retained earnings from CET1 to reflect market pressures to pay dividends. • The U.S. rule includes all retained earnings in CET1 even though commercial banks are authorized to distribute retained earnings in amounts up to current year earnings plus net income for the two previous years. If the FCA does not change its position to treat retained earnings differently from the Basel III framework and the U.S. rule, it should impose only criteria applicable solely to retained earnings. • Basel III and the U.S. rule do not apply any of the CET1 criteria to retained earnings. The FCA's proposed rule inappropriately applies the criteria to “allocated retained earnings,” including minimum revolvement periods established in capitalization bylaws. The System Comment Letter correctly states that Basel III and the U.S. rule fully include “retained earnings” in CET1 and do not apply to retained earnings any of the CET1 criteria they apply to equities. Our treatment of URE is identical to the treatment of “retained earnings” in Basel III and the U.S. rule. In our view, equating URE with the “retained earnings” in Basel III and the U.S. rule is correct because, to our knowledge, all the retained earnings of institutions covered by Basel III and the U.S. rule are unallocated. Our research has not revealed any financial cooperatives or mutuals under the Basel III framework or the U.S. rule that allocate equities. All the System's comments about treatment of retained earnings pertain only to our treatment of earnings that have been allocated to their members. Rather than establishing tiers of retained earnings, a structure the System's comment seems to both criticize and recommend, we treat allocated equities the same way we treat purchased equities, consistent with the provisions of the Act and our existing capital regulations. Most of the System's critical comments about our treatment of allocated equities have to do with the capitalization bylaw requirement and the requirement for prior approval of revolvements of allocated equities that do not fit within the safe harbor (“deemed prior approval”) provision. We address these criteria-related comments when we discuss the bylaw and minimum holding period requirements later in this preamble. We address here our basis for treating allocated equities the same way we treat purchased equities. We treat earnings that a System institution has allocated to a member as equities, irrespective of whether the institution calls them allocated equities, allocated stock, allocated surplus, or allocated retained earnings. “Allocated equities” is the term we use in existing capital regulations and also used in the proposed rule. The Act and existing FCA capital regulations most commonly use the term “allocated equities” and treat them as stock; in the Act and our regulations URE is consistently treated differently from stock and allocated equities. We note that the term “allocated retained earnings” used in the System Comment Letter could potentially confuse third-party investors who are not familiar with the allocation process and may not understand the ownership attributes that attach once the earnings are allocated. 18 In addition, the term is not found in the Act. The closest similar term is in section 4.3A(a)(1) of the Act, which defines permanent capital to include the following: (1) “Current year retained earnings,” (2) “allocated and unallocated earnings,” (3) “all surplus,” (4) stock that is not protected stock and that is not retireable at the discretion of the holder, and (5) other debt or equity instruments that the FCA determines appropriate to be considered permanent capital. “Allocated and unallocated earnings” may appear to be a separate and distinct category, but it overlaps with the categories of “current year retained earnings” and “surplus.” “Allocated and unallocated earnings” also expressly overlaps with “stock,” because paragraph (a)(2) of section 4.3A, which immediately follows the definition of permanent capital, further defines “stock” to include “voting and nonvoting stock (including preferred stock), equivalent contributions to a guaranty fund, participation certificates, allocated equities, and other forms and types of equities.” Other than the single, ambiguous reference to “allocated and unallocated earnings” in section 4.3A(a)(2) of the Act, the System's similar term “allocated retained earnings” is not a term used in the Act or our regulations. It has been rarely, if ever, used in FCA bookletters, informational memoranda, or Federal Register preambles. 19 18 A review of recent financial reports shows that some System institutions refer to allocated equities as “allocated retained earnings” in the reports, some institutions use both terms, and other institutions do not use the term “allocated retained earnings.” The [Federal Farm Credit Banks] Funding Corporation notably does not use the term “allocated retained earnings” in its Annual and Quarterly Statements that provide information for investors in the debt securities jointly issued by the four System banks. 19 In a search of FCA databases, we found two instances of a definition of allocated equities as including “allocated retained earnings and allocated stock” in the Capital Management section of the FCA examination manual. We note that, in the preamble to the proposed rule, our Table 2 comparing cooperative capital to the capital of a joint-stock bank incorrectly categorized “allocated surplus” as comparable to retained earnings but categorized allocated stock as comparable to common stock. Many provisions of the Act treat URE and allocated equities in separate ways. Section 4.9A(d) of the Act, which defines and guarantees full repayment of “eligible borrower stock,” defines borrower stock to mean “voting and nonvoting stock, equivalent contributions to a guaranty fund, participation certificates, allocated equities, and other similar equities that are subject to retirement under a revolving cycle issued by any System institution and held by any person other than any System institution.” URE is not protected under section 4.9A of the Act. Sections 2.6 and 3.10 of the Act establish that associations and CoBank, ACB have liens on the stock and equities, including allocated equities, of their retail borrowers. In section 3.2(a)(2)(A)(ii) of the Act, voting by a bank for cooperatives' retail borrowers is based on a stockholder's proportional equity interest “including allocated, but not unallocated, surplus and reserves.” Retirement of stock for a bank for cooperatives as provided in sections 3.5 and 3.21 of the Act treats the retirement of allocated equities the same as the retirement of “issued” equities. In section 6.4 of the Act, which pertains to the Assistance Board's certification of a System institution to obtain financial assistance by issuing preferred stock, allocated equities are treated as stock. Section 6.26(c)(1)(B) of the Act, pertaining to the repayment of financial assistance by the System, bases part of the repayment amount on an institution's amount of URE but not allocated equities. Existing FCA capital regulations are consistent with the Act's separate treatment of URE and allocated equities. Section 615.5330(b)(1) provides that a portion of core surplus must consist of URE and other includible equities other than allocated equities. A provision for banks for cooperatives that was in effect until 1997 required those banks to add at least 10 percent of their net earnings to their unallocated reserve account each year until URE equaled half the minimum permanent capital requirement (3.5 percent of risk weighted assets). 20 20 This requirement was in previous § 615.5330 and was rescinded in 1997 when the FCA adopted the net collateral ratio for banks. Under that previous regulation, we permitted CoBank, ACB to meet the URE requirement with nonqualified allocated equities, issued to its retail borrowers, that CoBank, ACB had a confirmed plan not to revolve except in liquidation. Such treatment is similar to the “URE equivalents” treatment for the capital conservation buffer in the proposed rule. Though the reason for treating allocated equities differently from URE is not expressly stated in the Act, the difference is likely based on the ownership attributes of allocated equities that make allocated equities stock-like in nature. The rule's treatment of allocated equities as stock and its treatment of URE as equivalent to the “retained earnings” in Basel III and the U.S. rule are consistent with the treatment of allocated equities and URE in the Act and existing FCA regulations. 3. Required Minimum Redemption/Revolvement Periods The proposed rule provided for minimum redemption and revolvement periods (holding periods) as part of the criteria for including equities in the new regulatory capital components. We proposed a minimum 10-year holding period for inclusion in CET1 capital and a minimum 5-year holding period for inclusion in tier 2 capital. In addition, consistent with Basel III and the U.S. rule, we proposed a 5-year no-call period for inclusion of equities in additional tier 1 capital and tier 2 capital, as well as a minimum 5-year term for term stock includible in tier 2 capital. The System Comment Letter did not object to the minimum no-call periods or minimum term for term stock but expressed objections to the minimum redemption and revolvement periods as follows: • The minimum holding period should be eliminated because there is no basis for it in Basel III. • An allocated equity with an express minimum term of 10 years is no more permanent than an allocated equity that is perpetual on its face. • The FCA has historically expressed a concern with member pressure on institutions for the payment of patronage or redemption of allocated retained earnings. Factually, System institutions do not face greater pressure to distribute allocated equities than the pressure on commercial banks to make dividend payments. • Several System institutions in the years 2007-2013 suspended cash patronage payments or reduced allocated equity redemptions when they experienced credit and business issues. Loan volume declined in some instances due to more conservative lending practices but not to borrower flight. The institutions resolved their credit and business issues and resumed cash patronage payments and increased allocated equity redemptions. This demonstrates that System institution retained earnings should qualify as CET1 without application of any limiting criteria. • If FCA remains resolute in treating allocated equities differently from URE, the agency should continue the requirements in existing FCA regulations based on minimum revolvement periods: A plan or practice not to revolve CET1 equities for at least 5 years and not to revolve additional tier 1 equities for at least 3 years, with no minimum revolvement period for tier 2 equities. • If FCA decides to adopt minimum holding periods as set forth in the proposed rule, a minimum holding period of 7 years for inclusion in CET1 capital would be more workable and reasonable. The System is correct that Basel III does not include a minimum redemption or revolvement period for CET1 equities or tier 2 equities. Such a minimum holding period is not necessary in the Basel framework or in the U.S. rule because commercial banks must obtain their regulator's approval before redeeming any equities, no matter how many years the equities have been outstanding. System institutions, likewise, will be able to redeem or revolve equities before the holding period ends if the institutions receive FCA approval. 21 What System institutions will be able to do that commercial banks cannot do is redeem and revolve equities under the safe harbor provision without submitting a request for approval to the FCA, provided the applicable minimum holding period has been completed. 21 We note, however, that FCA does not anticipate approving early redemptions and revolvements routinely. We do not understand the System's comment that an allocated equity with an “express minimum term of 10 years is no more permanent than an allocated equity that is perpetual on its face.” In the proposed rule, no term equities were included in CET1. On the contrary, only equities that were both perpetual “on their face” and held for at least 10 years were includible in CET1, and term (limited-life) equities were includible only in tier 2. It is true that, when an institution is placed into receivership, equities held by the institution at that point in time are available to absorb losses of the institution, regardless of whether the equities are perpetual or term and regardless of whether they have been outstanding for 10 years or for 10 days—in a receivership, every equity is as “permanent” as every other equity. We also acknowledge that, like the water level in a bathtub, the capital level of an institution will stay constant if the amount of new capital added is equal to the amount of capital the institution redeems, revolves, or otherwise pays out in cash. 22 But this is not the model of “permanency” embodied in the Basel III framework or the U.S. rule. On an ongoing basis, a reliance on a constant replenishment of new “permanent” capital to replace frequently redeemed or revolved “permanent” capital is inappropriately risky in a weak economy. 22 This bathtub analogy pertains to the dollar amount of a capital component. Of course, even with a constant dollar amount the capital ratio will change if the amount of risk-based assets changes or if the institution incurs losses. The FCA believes that longer revolvement cycles benefit System institutions by enabling them to better capitalize asset growth while also improving the quality and quantity of capital, thus strengthening an institution's financial position. A System institution, like most cooperatives, has limited opportunities to raise capital other than through the direct sale of stock to member-borrowers, the sale of preferred stock to outside investors, and the retention of net income as URE or allocated equities. System associations in particular have adopted the statutory minimum borrower stock requirement of the lesser of $1,000 or 2 percent of the loan, and only one association has issued preferred stock to outside investors. Thus, a System institution is highly dependent on its ability to generate sufficient earnings to repay its creditors, pay cash dividends to outside investors, pay cash patronage to its member-borrowers, and add to its capital base. Cooperative institutions can pay patronage to their member-borrowers in three forms: (1) Cash, which is an immediate return; (2) allocated equities that may be revolved at some future date; or (3) a combination of cash and allocated equities. Allocating equities allows the institution to use this capital for a period of time to benefit the whole cooperative membership, such as for capitalizing growth or improving the financial condition. Many boards choose to revolve allocated equities on an approved cycle, provided that the institution can continue to meet its capital needs. Thus, capital planning assumes greater importance in the capital adequacy assessment for the System institution's long-term survival. Academic and professional studies 23 conducted of agricultural cooperatives' patronage practices by the U.S. Department of Agriculture (USDA) and others have shown that longer allocated equity revolvement cycles result in stronger balance sheets and a more resilient cooperative. Institutions that maintain shorter revolvement cycles will have greater need to generate proportionally more earnings consistently to maintain the same level of capitalization. The USDA reported, “The largest cooperatives redeemed equity more recently but had a revolving length at 17 years, which was 4 years longer than the smallest cooperatives.” Those cooperatives surveyed reported a range of revolvement periods from 7 to 20 years. Some cooperatives also reported retiring equities when a farmer was between 66 years and 72 years of age. Service cooperatives had the shortest revolvement periods at 6 years; and livestock, poultry, and wool cooperatives had revolvement periods of 7 years. 24 This study concluded that cooperatives with shorter revolvement cycles are generally more leveraged and less resilient. 25 23 See, e.g., Robert C. Rathbone and Roger A. Wissman, Equity Redemption and Member Equity Allocation Practices of Agricultural Cooperatives, Agricultural Cooperative Service, U.S. Department of Agriculture (USDA), ACS Research Rep. No. 124 (October 1993); Kimberly Zeuli and Robert Cropp, Cooperatives: Principles and Practices in the 21st Century, University of Wisconsin Center for Cooperatives (2004). 24 See E. Eldon Eversull, Cooperative Equity Redemption, Rural Business—Cooperative Programs, USDA, Research Rep. No. 220 (June 2010) at 6-7. 25 See Rathbone and Wissman at 10-11. Longer revolvement periods give an institution extra flexibility when earnings are stressed, as well as help maintain stronger capital levels when membership or existing borrowers' operations grow. The FCA strongly believes that System institutions, as financial cooperatives with GSE status, must have redemption and revolvement periods that are sufficiently permanent to maintain strong capital positions in a weak economy. On the issue of whether System institutions face greater pressure to revolve allocated equities than the pressure on commercial banks to make dividend payments, we disagree with the System. It has long been our position that members can exert more pressure on their institutions because of their dual relationship as borrowers and voting stockholders; by contrast, the voting stockholders of a commercial bank rarely, if ever, have significant business ties with the bank. In other words, unhappy stockholders of a commercial bank do not necessarily or directly lead to a drop in the bank's business. We are particularly concerned about the circumstance of a System institution experiencing low earnings and low growth because the agricultural economy is weak and their borrowers are struggling and most need cash. We acknowledge that the pressure on System institutions to pay cash patronage payments may be comparable to the pressure on commercial banks to pay cash dividends to their stockholders, but we note that the expectation criterion in our proposed and final rule does not apply to cash patronage paid out of URE just as it does not apply to cash dividends paid out of a commercial bank's retained earnings. Commenters asserted that they did not experience borrower flight during the years 2007-2013 even given some institutions' reductions in patronage payments. FCA staff has reviewed the patronage payment activities of a number of System associations in the years 2007-2013 leading up to and after the 2008 global financial crisis. Though the financial crisis was deep in many sectors of the U.S. economy, the agricultural economy suffered little impact. Most System institutions had little or no exposure to the “toxic” assets that crippled many financial institutions because of the System's limited lending and investment authorities. In fact, many institutions continued to grow their loan volume. Some impacted institutions did reduce or suspend cash patronage payments and planned redemptions of allocated equities. They did so for a variety of reasons, including to address financial stress and to support increased loan demand. While the experiences of 2007-2013 are useful for analysis, there were no widespread or significant changes in patronage payment practices in the System, particularly redemption or revolvement of allocated equities. Thus, we do not believe these experiences are a strong indicator of what System institutions would experience in a severely weakened agricultural economy. In the proposed rule, we also intended the minimum holding periods to provide a way for System institutions to comply with the Basel III and U.S. rule's expectation criterion. The expectation criterion, a new concept in Basel III and the U.S. rule, is part of the criteria for all 3 capital components—CET1, AT1, and tier 2 capital. For CET1, the U.S. rule provides that a commercial bank must not “create at issuance of the instrument, through any action or communication, an expectation that it will buy back, cancel, or redeem the instrument, and the instrument [must] not include any term or feature that might give rise to such an expectation.” The criteria for AT1 and tier 2 are the same except that the expectation is with respect to exercising a call option on the instrument rather than buying back, redeeming, or canceling it. It is our understanding that this criterion is intended to curb actions like those of some commercial banks that continued to make large share buy-backs and dividend payments during the 2008 global crisis, in order not to send investors a signal of weakness. 26 26 The Basel III document does not specifically discuss the expectation criterion. However, in a discussion of the need for a capital conservation buffer there is an explanation that we believe applies equally to the expectation criterion: “At the onset of the financial crisis, a number of banks continued to make large distributions in the form of dividends, share buy backs and generous compensation payments even though their individual financial condition and the outlook for the sector were deteriorating. Much of this activity was driven by a collective action problem, where reductions in distributions were perceived as sending a signal of weakness. However, these actions made individual banks and the sector as a whole less resilient.” Basel III Framework (December 2010, revised July 2011), paragraph 27. There are two noteworthy aspects of the expectation criterion. First, it does not pertain to the intentions—implicit or explicit—of the commercial bank to redeem the instrument, but rather to the expectations created by the bank's behavior—its “actions or communications”—and the focus is on the impact of the bank's actions on others and its communications with others that could lead the bank to redeem stock when such redemption could potentially weaken the bank. The “others” in question could be stockholders, potential investors, the market, or banking analysts and traders. Second, all the other criteria for CET1 and the other components of capital are based on primarily objective legal rights, legal status, or accounting principles. 27 They cover, for example, perpetual status (“no maturity date”), liquidation priorities and claims, order of impairment, unsecured status without features that legally or economically enhance the seniority of the instrument, redemption only at the discretion of the board and with the regulator's approval, and classification as equity under GAAP. By extension, these criteria mirror the legal rights that a commercial bank's common stockholders have or do not have. The stockholders have no legal right to require the bank to retire or redeem their stock because the stock never matures and because the commercial bank has complete discretion whether to redeem it (with regulatory approval). The expectation criterion does not pertain to legal rights regarding a stockholder's equities; the criterion pertains only to behavior or a pattern of behavior by the commercial bank that leads the stockholder or the market to expect redemption. The FCA has a similar concern regarding the expectations that System institutions may create through their behavior and communications. 27 One criterion that is less objective is the requirement that the instrument does not include any term or feature that “creates an incentive to redeem.” However, the Federal banking regulatory agencies have previously provided objective standards for commercial banks of the types of terms that create incentives to redeem, such as a dividend step-up term in excess of a specified percentage increase. The concept of a minimum holding period for System cooperative equities has been a part of FCA's existing core surplus capital regulations that have been in effect since 1997. Under that regulation, an association may include in core surplus allocated equities with an original revolvement period of at least 5 years, as long as such equities are not scheduled by the board or a board practice or expected by the members to be revolved in the next 3 years. The exclusion from core surplus in the last 3 years before revolvement focuses the board on longer-term planning to replace the soon-to-revolve allocated equities and better enables the board to revolve the allocated equities as expected, without reducing the institution's core surplus ratio. The core surplus regulation reflected the Agency's judgment that, first, member expectations of revolvement increase as the revolvement date approaches and, second, minimum revolvement periods make the equities more stable. 28 28 The FCA decided not to retain the existing regulation's plan-or-practice standard for allocated equities included in core surplus or the requirement to phase the equities out of CET1 in the 3 years before the end of the holding period. Over the years since we adopted the core surplus rule, a number of institutions have misinterpreted their yearly revolvements of allocated equities as not constituting a plan or practice of revolvement. They have erroneously included allocated equities in core surplus until revolved, rather than phasing them out. We believe eliminating the possibility of misinterpretation is the better course in the final rule, and the longer holding period will ease any concerns about including the equities in the new regulatory capital ratios until the date of revolvement. The fundamental purpose of allocating equities is to build capital by retaining earnings as opposed to distributing them out as cash. As such, allocated equities need to be sufficiently permanent for the institution to include them in capital. Equities revolved in only a 2- or 3-year period have minimal economic substance or value from a capital perspective, and revolvement periods shorter than 5 years may result in unmanageable borrower expectations and significantly reduced board flexibility to temporarily suspend or defer redemption of allocated equities. Longer revolvement periods ensure these equities are more permanent and stable forms of capital. Since 1997, System institutions have remained adequately capitalized with the existing core surplus rule's 5-year revolvement minimum. However, the agricultural economy and most System institutions have been financially healthy since that time. As we stated above, we believe a longer minimum holding period for the highest quality capital is more appropriate to ensure adequate capital when the agricultural economy is weak. We believe the holding period for CET1 capital should be longer than the similar 5-year no-call minimum period for lower quality additional tier 1 and tier 2 capital and the minimum term of 5 years for term stock includible in tier 2 capital. The 10-year minimum holding period for CET1 capital in our proposed rule would, in our view, have both tempered member expectations of redemption or revolvement and ensured the stability of capital through the long cycle of the agricultural economy. However, we have considered the System's comments for a shorter minimum holding period for CET1 equities, in light of the rule's other provisions that ensure the retention and conservation of high quality capital, such as the safe harbor provision and FCA prior approval requirements, and the overall higher capital requirements of the rule. We have concluded that a minimum 7-year redemption and revolvement period for CET1 equities will give System institutions added flexibility to manage their capital planning without significantly impacting their resilience. As we have noted, many of the System institutions that revolve allocated equities have already extended, or begun to extend, their revolvement periods to 7 years or longer. The final rule's shorter minimum CET1 holding period, together with our change in the final rule to permit institutions to commit to the minimum holding periods through an annual board resolution, should enable institutions to comply with the new capital requirements with minimal administrative burden. We have decided not to adopt the System's recommendations of a 3 to 5-year minimum holding period for additional tier 1 capital and elimination of the minimum holding period for tier 2 equities. To do so would be inconsistent with the minimum no-call periods of 5 years for additional tier 1 and tier 2 capital in Basel III and the U.S. rule. Furthermore, elimination of the tier 2 minimum holding period would imprudently permit redemptions and revolvements of equities, such as the member equities issued by some System banks in connection with loan participation programs and the preferred stock issued by some associations to their members, that have been outstanding for as short a period as 1 quarter. In the final rule, we have retained the 5-year minimum holding periods for both additional tier 1 capital and tier 2 capital. 4. Minimum Redemption/Revolvement Cycle for Association Investments in Their Funding Banks The System Comment Letter objects to the proposed rule's imposition of minimum redemption and revolvement periods on associations' investments in their funding banks. The proposal provided that these investments, which consist of both purchased and allocated equities, have the same minimum redemption and revolvement periods as all other cooperative equities. The System makes the following assertions about the proposed rule's minimum holding period requirement for the association investments in their banks: • It is challenging, bureaucratic, unworkable, anti-cooperative, costly, and burdensome without any discernible benefit in capital quality or quantity, and it is unnecessary to achieving alignment of System capital regulations with Basel III. • It is inconsistent with statutory requirements, creates a “first in first out” redemption principle for the investment, impedes a bank's ability to help a struggling association by redeeming or revolving equities, and could create an adverse tax consequence that would necessarily dissipate combined bank-association capital. • An association's investment in its funding bank “is legally and functionally a permanent capital contribution to the bank and is understood as such by associations,” notwithstanding periodic capital equalizations by the System bank (which result in member associations' investments being adjusted, as necessary, to the same specified percentage of its outstanding borrowings from the bank). • An association's investment in its funding bank “results from the statutorily directed financial relationship.” System associations must borrow exclusively from their bank unless they have approval from the bank to borrow from another financial institution. By contrast, an association's borrowers are free to borrow outside of the System. • The investment requirements imposed on retail borrowers by associations are unlike those imposed by a System bank on its affiliated associations, since associations do not have unilateral authority to increase the requirements. System banks have bylaws that authorize them to call, preserve, and build capital from their associations. Also, a bank's general financing agreement with its affiliated association enables it to increase spreads on outstanding direct loans immediately without association approval. The capital rule is consistent with statutory requirements. The rule applies the same minimum redemption and revolvement cycles to all cooperative equities except for the statutorily required investment of at least $1,000 or 2 percent of the loan amount, whichever is less. Stock or equities that meet this statutory requirement are exempt from a minimum redemption or revolvement period. We agree with the System that System banks and associations have a relationship defined by the Act that is long term and permanent except for very rare re-affiliations with another System bank or a termination of System status by one or both institutions. However, the statutory minimum required investment is the same for an association to obtain a loan from its affiliated bank as it is for a retail borrower to obtain a loan from an association or from CoBank, ACB, and the exemption from a minimum redemption or revolvement period in our rule applies only to the statutory minimum required investment. We are not persuaded by the System's position that System banks have authority to call, preserve, and build capital from their associations that their associations lack. Associations have the same statutory and regulatory authority as banks to call, preserve, and build capital; it is the associations that have granted additional capital-building powers to their affiliated banks through bylaw provisions approved by the associations. We appreciate that associations are probably more willing to approve such bylaws because of their financial interdependence with their bank, and association retail members are probably less willing to commit themselves to purchase additional stock in the association. However, the capital-building provisions in a bank's bylaws do not eliminate the need for capital to have a minimum redemption or revolvement period. The System Comment Letter states that the minimum holding period creates a “first in first out” redemption principle for the investment and impedes a bank's ability to help a struggling association by redeeming or revolving equities. As to the first point, we are not certain what is meant by “first in first out” in the context of a redemption principle, unless it is merely another way to say that associations may have to pay taxes on allocated equities revolved by their banks. The minimum required holding period clearly does not impose a strict requirement that the oldest equities must be redeemed or revolved first. As to the second point, we note that a System bank may redeem or revolve equities prior to the minimum holding period if the bank receives prior approval to do so from the FCA. We believe that the FCA would have a sufficient basis to approve such a request if the bank established that its assistance was necessary or appropriate. The FCA disagrees with the System's assertion that an association's investment in its affiliated bank “is legally and functionally a permanent capital contribution to the bank and is understood as such by associations.” Most System associations do clearly have very long relationships with their affiliated banks, but not all of the equities invested by an association in its affiliated bank are outstanding for lengthy periods. In fact, it appears to us that associations well understand that some of their investments in their affiliated banks are only short-term investments. System banks have discretion under section 4.3A(c)(1)(I) of the Act to redeem and revolve equities anytime, as long as the bank continues to meet the capital adequacy standards established under section 4.3(a) of the Act. By contrast, the CET1 equities issued by commercial banks are more truly permanent, because commercial banks are not permitted to retire such equities without the approval of stockholders owning two thirds of the shares (a statutory requirement) or without the prior approval of their regulator (a requirement of the U.S. rule). Similarly, tier 2 equities issued by commercial banks either are perpetual and require prior approval by their regulator to retire, or are limited-life preferred stock with a minimum term of 5 years (with no prior approval to retire on the maturity date). In our view, third-party investors, relying on an understanding that our capital rules are comparable to Basel III and the U.S. rule, would expect that System institutions' common cooperative equity retirements are subject to substantially the same prior approval requirements as commercial banks' equity retirements. 29 Our proposed rule was somewhat more lenient than the restrictions on commercial banks' equity redemptions in that we did not require banks or associations to obtain stockholder approval before each redemption or revolvement of cooperative equities. We provided additional leniency in a safe harbor provision permitting a certain level of redemptions and revolvements without FCA approval, as long as the equities had been outstanding for at least the minimum holding period. Commercial banks do not have a similar safe harbor for equity retirements, although they do have a safe harbor for cash dividends. We believed, and continue to believe, that our more lenient safe harbor for equities is appropriately comparable to Basel III and the U.S. rule because the safe harbor's broader application to total cash dividend payments, cash patronage payments, and equity redemptions or revolvements is tempered by an overall limit that is more restrictive than commercial banks' safe harbor to pay cash dividends. 29 It is important to note that, if a System bank includes its affiliated associations' investments in the bank's CET1 capital, those investments will be the common cooperative equities of most interest to a third-party investor in the bank and will likely be a factor, even a significant factor, in such investor's decision whether to invest in a System bank. After all, the bank's URE and CET1 common cooperative equities are the first line of protection for the outstanding third-party equity investments in System banks. If there were no minimum redemption or revolvement period for these cooperative equities, a third-party investor might misunderstand the level of protection these cooperative equities actually provide. For many associations, the greater part of their investments in their affiliated banks is long term in practice. These investments include equities the banks allocated more than 10 years ago, and the banks have stated they do not intend to revolve these allocated equities unless their associations make corresponding allocated equity revolvements to their retail borrowers. Some of these allocated equities are quite stable, due in part to the fact that they are not taxable to associations until they are revolved (System banks' earnings derived from association business are not taxed). 30 As soon as the final rule becomes effective, the banks will be able to include otherwise-eligible allocated equities in CET1 that have already been outstanding at least 7 years (or tier 2 if the allocated equities have been outstanding at least 5 years), and all other allocated equities will be includible in CET1 or tier 2 if the banks adopt a bylaw or annual resolution not to redeem or revolve such equities less than the applicable 7 years or 5 years after issuance or allocation, as long as the equities are otherwise eligible. 30 An association's earnings are taxable only when derived from its loans and other business conducted through the parent agricultural credit association or its production credit association subsidiary. However, many associations have investments in their banks that do not have the same stability and “permanence” of the long-held allocated equities. Some of these investments may be the stock purchased by associations to capitalize their direct loans from their banks; other stock is purchased by associations in order to capitalize asset loan participation program pools. Because the capital supporting these loan pools is usually equalized frequently by the bank, banks typically equalize by issuing or redeeming purchased stock because there are no tax consequences when the purchased stock is redeemed. The FCA observes that the practice of tying the investment amount to the loan amount and making frequent equalizations strongly resembles the “compensating balance” method of capitalization that both banks and associations employed in past decades— i.e., the borrower capitalized its loan rather than capitalizing the institution. During the 1980s, many System associations were in such weak financial condition they could not redeem member stock; the also-struggling member-borrowers strongly objected to those associations' not returning their investments when they paid down or paid off their loans, and Congress held a hearing to obtain the testimony of the borrowers. In the Agricultural Credit Act of 1987 (1987 Act), Congress established a statutory capitalization framework that favored capitalization of the institution, not the loan, and disfavored compensating balances, though it did not prohibit them entirely. The FCA believes, as Congress did, that capitalization of the institution rather than the loan provides a stronger and more stable capital base. At the retail level, all System institutions now require borrowers to make only the statutory minimum stock purchase, and in the nearly two decades since the enactment of the 1987 Act System institutions have taken advantage of a healthy agricultural sector to build strong capital positions of high-quality capital that remain in the institutions long term. In addition, one of the four System banks has made the decision not to equalize association investments any longer; instead, the bank pays interest to its associations who hold investments in the bank in excess of the required amount. We acknowledge that stock equalization at the bank level can be a tool for apportioning the bank's funding and operating costs among its affiliated associations. The FCA supports an equitable apportionment that is based on each association's business with the bank and investment in the bank. However, short-term redemptions and revolvements of equities are not the sole way to ensure that costs are borne equitably by the associations. There are numerous other ways of apportioning the bank's operating costs, such as direct assessments or interest rate adjustments or paying interest to associations whose investments are in excess of bank's required amounts, that take into account the amount of loaned funds or other business with associations and the riskiness of that business. Should a bank prefer to apportion its funding and operating costs in part by equalizing association investments and at the same time hold most of its purchased stock for a term long enough to qualify for CET1 or tier 2 inclusion, it may consider issuing a class of common stock used solely for equalization purposes. The amount a bank might issue could be, for example, an amount equal to the average amount of equities the bank redeems in a given period for purposes of equalization. Such stock, which could be exchanged for a portion of existing outstanding common stock, could be issued and retired at the discretion of the bank and would have no minimum revolvement period, but it would be excluded from CET1 and tier 2 capital. This would by no means eliminate the minimum revolvement period for an association's investment in its affiliated bank, but having a separate class would provide more administrative clarity for the bank, the FCA, and third-party investors. 5. Required Capitalization Bylaws Amendments Establishing Minimum Holding Periods The System Comment Letter objected to the proposed rule's provision that a System institution may include cooperative equities in CET1 and tier 2 capital if the institution has adopted capitalization bylaws establishing minimum required redemption and revolvement periods. The proposed minimum redemption and revolvement periods, or minimum holding periods, were 10 years for inclusion in CET1 capital and 5 years for inclusion in tier 2 capital. Because section 4.3A(b) of the Act requires System institutions to obtain the approval of their members for changes to the bylaws, institutions would have had to exclude cooperative equities from CET1 and tier 2 capital if they had chosen not to seek member approval of the bylaw amendment or if the members had disapproved it. The System made the following assertions about the proposed capitalization bylaw requirements: • They are legally tantamount to a re-issuance of the cooperative equities. • They are fundamentally unworkable, unnecessarily costly, and legally problematic, and they result in a meaningless vote that puts the System institution and its members in a Catch-22 situation. • The bylaw changes would undermine the institution's ability to function consistent with cooperative principles as expected by the Act. Institutions with modest amounts of cooperative equities may choose to exclude their cooperative equities from regulatory capital than bear the cost, operational burdens, member confusion, and uncertainty of a member vote. If a significant number of institutions make this choice, there could be resulting harm to the overall regulatory capital position of the System. • Holders of allocated equities that are not voting members may sue the FCA for depriving them of the right to have the institution's board forgo exercising its discretion to revolve the equities during the minimum holding periods. • There is no basis for a minimum holding period in Basel III. • A more cost-effective way to ensure there is a legal distinction among equities included in the various components of regulatory capital is to enhance the FCA's capital planning regulation to require boards to adopt binding resolutions regarding the minimum holding periods. The proposed bylaw requirement to establish a minimum holding period was intended to provide a way for System institutions to comply with the Basel III and U.S. rule's “expectation” criterion. We discuss the expectation criterion under the “Required Minimum Redemption/Revolvement Periods” above. The FCA's proposed minimum holding periods were also intended to ensure that System institutions equities are substantially comparable to the more truly permanent equities of a commercial bank that can be redeemed only with the prior approval of stockholders and the bank's regulator. Were we to apply identical requirements, System institutions would not be able to redeem or revolve any purchased or allocated equities without FCA approval and stockholder approval. As discussed under the safe harbor section below, the proposed rule would have permitted institutions to make limited redemptions and revolvements without regulator and stockholder approval. We believe that a minimum holding period lowers expectations of redemption or revolvement, and the bylaw requirement ensures both institution compliance and member buy-in regarding the minimum periods. A bylaw requirement would have explicitly established that a System institution's board had firmly committed, with its members' support, to limit its discretion under section 4.3A of the Act to redeem or revolve equities, in exchange for being able to include the equities in tier 1 and tier 2 capital, and that the institution's members understood and supported this limit on the board's discretion. However, we have considered the System's comments on the bylaw approval process and are persuaded that requiring an institution's board to adopt a redemption and revolvement resolution that it must re-affirm in its capital plan each year would be sufficient to ensure compliance with the rule's minimum holding periods. As described below in the section-by-section discussion, we have revised the capital planning regulation in § 615.5200 to require the institution's board to establish minimum redemption and revolvement periods for specifically identified equities included in tier 1 and tier 2 capital. Any change to the minimum periods will require FCA approval. The board will also be required to re-affirm annually its intention to comply with the capital rule's minimum holding periods. We note that this annual re-affirmation is not an annual opportunity for the board to change its mind about the redemption or revolvement periods of specified equities. In addition, for institutions that prefer a capitalization bylaw to an annual board resolution, we have retained the proposed capitalization bylaw provision as another method of compliance with the minimum holding periods. 6. Higher Tier 1 Leverage Ratio and Minimum URE and URE Equivalents Requirement The System Comment Letter objected to the proposed 5 percent minimum tier 1 leverage ratio and also on the requirement that at least 1.5 percent of the tier 1 capital must consist of URE and URE equivalents. The System's objections are as follows: • A 5-percent tier 1 leverage ratio requirement is excessive, is unsupported, is inconsistent with the 4 percent tier 1 leverage ratio of Basel III and the U.S rule, would create an un-level playing field that gives an advantage to commercial banks in the capitalization of loans to farmers, and may raise questions and suspicion that the System is fundamentally riskier compared to other lending institutions. • Such an inference does irreparable harm to the System and its mission achievement, given the lack of any quantifiable support for the higher minimum. The FCA has not provided “reasonable facts or data analysis” to support a higher minimum leverage requirement that could reduce institution lending capacity by over 20 percent during stressful periods. The FCA's justification is insufficient and unsupported by loss experience, making this proposed requirement arbitrary and capricious. • The Basel III framework's minimum leverage ratio requirement, a measurement that was not required by Basel I or Basel II, was imposed in response to the “drying up” of liquidity during the financial crisis, which revealed inter-connections and inter-dependences between financial institutions and resulted in pressure on commercial banks to retire lower quality tier 1 capital instruments (hybrid instruments) when they were most needed to absorb losses. Stress-testing and economic modeling by System institutions show the System has enough loss-absorbing capital to withstand a severe adverse economic event while continuing to provide a steady flow of credit to agriculture. • The interconnectedness of System institutions is an inherent part of the structure of the System and, despite its interconnectedness and its status as a monoline lender, the System remained “essentially unstressed” during the financial crisis. • The proposed minimum leverage ratio is inappropriate for wholesale System banks and appears to create economic incentives for shifting ownership of loans from associations to System banks. The agency “appears not to have considered the two-tiered capitalization that exists within the System” that results in the System as a whole effectively holding minimum risk-based capital for association retail loans totaling 120 percent of the amount required for commercial banks. The risk-based capital requirements are more than adequate to protect against not only credit risk but also liquidity risk, operational risk, and other risks. • There is no empirical evidence that the System's risks are more significant than the systemic risks that caused the financial crisis. FCA should support its higher minimum leverage ratio by conducting a study that demonstrates and quantifies that the proposed significant deviation from Basel III is justified by facts. After such a study, if the FCA remains focused on imposing a higher leverage ratio, the agency should consider a 4 percent minimum leverage ratio with an additional 1 percent leverage ratio buffer composed of tier 1 (not CET1) capital and pro-rated across the payout categories. Overall, a capital conservation buffer approach would support the objective of the proposed higher leverage ratio without unduly penalizing those System banks primarily engaged in wholesale lending to associations. • The proposed 1.5 percent minimum URE requirement “calls into question the cooperative structure of the System” and “declares that URE is higher quality capital than CET1.” This “'super' or 'superior' CET1 subclass is an unmistakable message to the marketplace that the System's CET1 does not match up with CET1 of commercial banks” and reduces comparability and transparency. • Implementation of the URE requirement results in a minimum 3 percent of URE (1.5 percent by the bank and 1.5 percent by the association) required to be held against each dollar of loans made by associations to member-borrowers. This violates the cooperative principle that members bear the risk and reward of their institution. • The 1.5 percent minimum URE requirement, similar to a required component of the core surplus ratio in the FCA's existing regulations, should not be in the new capital framework. The FCA's reason for the existing URE requirement in core surplus was that higher URE levels cushioned member stock from impairment, thus minimizing the prospect of members seeking protection of their equities from Congress. Congress has already made it clear that members are at risk and will suffer the losses of the cooperative. Congress's action with respect to Fannie Mae and Freddie Mac emphasizes its resolve to allow significant shareholder losses regardless of personal impact. The FCA disagrees with many of the System's comments and assertions. We do not believe a 5 percent minimum standard would create an “unlevel” playing field for the System that would give any appreciable advantage to commercial banks or raise suspicions that the System is fundamentally riskier than commercial banks. At the retail association level, there are so many differences between associations and commercial banks with respect to stable sources of funding, lending authorities, lending territories, tax status, and governance that we believe a higher minimum leverage ratio would not tilt the playing field. A higher leverage ratio requirement enhances the System's ability to achieve its mission by ensuring that System institutions have sufficient capital to achieve its mission, during good times as well as during periods of financial stress. More specifically, a higher leverage requirement will ensure that System institutions have sufficient amounts of capital at the height of the credit cycle so that they can continue to lend during a downturn, and thus, fulfill their mission. During a downturn, System borrowers need access to credit to ensure the continuation of their operations, and System institutions must ensure that they can continue to be a reliable source of credit to these borrowers. Moreover, we do not believe that a higher minimum leverage ratio for associations will raise suspicions in the capital markets. To our knowledge, individual association capital is not the focus of the capital markets, as we are aware of only one association that has raised equity capital from outside the System. 31 31 In fact, market investors in System banks may prefer high capital ratios at associations on the ground that the associations' higher capital levels strengthen the banks and decrease the chances that a bank would need to provide financial assistance to an association. At the System bank level, the banks are able to issue Systemwide debt as a single entity because they are jointly and severally liable on the debt. The System's combined assets were approximately $300 billion as of December 31, 2015. By contrast, the vast majority of commercial banks subject to the 4 percent tier 1 leverage ratio requirement are considerably smaller in size than the combined size of the System. 32 Commercial banks subject to the “advanced approaches” Basel framework ( i.e., banks with more than $250 billion in total consolidated assets) are also subject to the supplementary leverage ratio (SLR), 33 which has a minimum requirement of 3 percent. The SLR, which takes into account both on- and off-balance sheet exposures, could result in a higher requirement than the 4-percent tier 1 leverage ratio requirement, which includes only on-balance sheet exposures. Commercial banks with more than $700 billion in total consolidated assets are subject to a 2-percent leverage buffer in addition to the 3-percent SLR (totaling 5 percent). 34 System banks, by contrast, are not constrained by a supplementary leverage ratio, yet they are able to obtain funding at low rates comparable to the rates obtained by the largest U.S. banks. We would anticipate that the capital markets and outside investors would welcome a higher leverage ratio requirement that ensures higher capital levels to absorb losses and protect outside investors, rather than “raise suspicion that the System is fundamentally riskier compared to other lending institutions.” 32 The System reported combined assets of $303 billion including the restricted investment in the Farm Credit Insurance Fund, at December 31, 2015. See 2015 Annual Information Statement of the Farm Credit System issued March 7, 2016. 33 78 FR 62018 (October 11, 2013). 34 79 FR 57725 (September 26, 2014). The FCA disagrees that the Basel III framework imposed a minimum leverage ratio requirement in response to the “drying up” of commercial bank liquidity during the financial crisis. The 2008 financial crisis did begin with a severe liquidity crisis, but liquidity concerns were addressed primarily by Basel III's liquidity coverage ratio and the net stable funding ratio. The FCA updated the liquidity regulation in 2013 to incorporate the liquidity coverage principles of Basel III, as appropriate to the System. 35 We also plan to study Basel III's liquidity coverage ratio and the net stable funding ratio to determine what, if any, application they should have to the System. 36 The leverage ratio requirements in the Basel III capital framework were adopted to avoid future repetition of periods of excessive growth, resulting in excessive leveraging of capital, that are followed by a sharp downturn in the economy that causes very large losses. 35 See the amendments to § 615.5134 in 78 FR 23438 (April 18, 2013). 36 See FCA's Regulatory Projects Plan at http://www.fca.gov/Download/RegProjPlanSpring2016.pdf . We agree with the System's statement that the System remained “essentially unstressed” during the financial crisis despite its status as a monoline lender and the interconnectedness of System institutions. In our view, while the cyclical nature of the agricultural economy can increase agricultural lending risk overall, the agricultural economy happened to be at a very strong point in the cycle during the financial crisis. The System's low level of agriculture loan losses during the financial crisis, together with minimal exposure to troubled residential mortgages due to legal restrictions on the loans and investments System institutions can make, enabled the System to weather the financial crisis relatively unstressed. Contrary to another System comment, the FCA did carefully consider the two-tiered structure of the System— i.e., the banks' wholesale funding of associations' retail loans—when proposing the tier 1 and tier 2 risk-based capital requirements. In fact, since the agency first proposed and adopted risk-based capital regulations in 1988, System institutions have consistently objected to the 20-percent risk weight applied to a bank's direct loan to an affiliated association and have asserted that the capital held by an association against its retail loans results in a zero risk of loss to the bank on the direct loan. Our position has been, and continues to be, that the direct loan represents a relatively small but separate and distinct credit risk to the bank, and the 20-percent risk-weight is appropriate, as well as consistent with the risk weightings for GSE securities and debt. We do not agree that the small amount of risk-based capital held by the System bank against credit risk on its direct loans, as well as the relatively small amounts of capital held against credit risks on most of its other exposures, is an adequate substitute for a tier 1 leverage ratio. As explained below, we believe that both System banks and associations need high quality minimum leverage ratios. The FCA disagrees with the comment that a leverage ratio is inappropriate for wholesale banks. A leverage ratio can be more challenging for a wholesale System bank, since the majority of its assets are risk-weighted at 20 percent, while those of associations are risk weighted at 100 percent. However, as discussed elsewhere in this preamble, the two-tiered capitalization requirement recognizes the separate risks in the System structure and risks that are present to each party. The capital an association holds against loans to its borrowers offsets the general risk from those loan exposures, while the bank must hold capital to offset the general risk from its loan exposure to its affiliated associations. If banks did not hold capital against these exposures, the risk in loans to association borrowers would be present to both the bank and association but only capitalized by the association. In addition, the banks and associations have levels of operational risk, such as legal risk and management risk, that do not correlate with the level of credit risk. The Basel III framework and the U.S. rule do not exempt wholesale banks from their leverage ratio requirements, and we are not convinced that we should do so. As for the System's comment that our leverage requirements appear to create an economic incentive for shifting ownership of retail loans to the System banks, banks and associations are already doing this. If a bank agrees with its associations to buy their retail loans, that is a business decision for the institutions that is probably made for business reasons in addition to regulatory capital compliance. We also disagree with the assertion that the minimum URE requirement is anti-cooperative. The requirement ensures at least a minimum level of URE and URE equivalents, and an institution may choose to meet this requirement with URE equivalents plus current year retained earnings. URE equivalents are nonqualified allocated equities that are not revolved and generally not subject to offset against a loan in default (without prior FCA approval). In any case, the characterization of URE as anti-cooperative is inapt for most cooperatively organized financial institutions, such as mutual savings associations. Such institutions have regulatory capital that consists entirely of unallocated retained earnings. We note that the National Credit Union Administration (NCUA) issued a final rule in 2010 for corporate credit unions (which are also cooperative institutions), 37 which requires that their leverage ratio must consist of at least 2 percent of retained earnings to be adequately capitalized. 38 The NCUA's logic and belief is that a corporate credit union's capital must consist of retained earnings, which is the only form of corporate capital, that when depleted, does not result in losses that flow downstream to natural person credit unions. Without some retained earnings, the corporate credit unions would be a continued source of instability to the credit union system as whole. FCA believes this also applies to System institutions, as discussed throughout this preamble. 37 75 FR 64789 (October 20, 2010). 38 To our knowledge, all of the retained earnings of credit unions are unallocated. The “corporate credit unions” discussed above are cooperatives owned by natural person credit unions and provide liquidity and other services to their member owners. We agree that Congress, in the provisions of the 1987 Act, sent a message that member stock was at risk and that members would be subject to their institutions' losses. 39 We also observe that Congress protected member stock outstanding at the time from loss. We believe this “helping hand” in a time of need illustrates Congress's confirmation of the importance to the entire U.S. economy of a strong agricultural sector and also of Congress's recognition that strength in the agricultural sector is inextricably linked to the personal financial stability of its farmers and ranchers. By contrast, in the case of the 2008 conservatorships of Fannie Mae and Freddie Mac, the actions of Congress and the Federal government ensured the continuing function of the secondary mortgage market for the benefit of U.S. homeowners but did not provide similar protection for the personal financial stability of the stockholders of the housing GSEs. 39 We emphasize that, before the 1987 Act, member stock was at risk, but most institutions treated it like a compensating balance, and many associations failed to advise their retail borrowers that the stock was at risk. The 1987 Act added a “guarantee” that existing outstanding member stock that was issued prior to October 1988 would be redeemed at par or face value upon repayment of the member's loan. The 1987 Act also sent a strong message to the System not to expect Congress to provide financial assistance in the event of significant losses in the future. 40 We believe this reinforced the FCA's mandate under section 4.3(a) of the Act to “cause System institutions to achieve and maintain adequate capital” that will have the added benefit of protecting the institutions' members from impairment of their equities. In our view, a healthy portion of URE and nonrevolving URE equivalents reduces the possibility that those equities will be impaired during times of stress in the agricultural sector. URE protects against the risk that exists between System banks and associations: It protects association members against association losses, associations against bank losses, and the System against financial contagion. A minimum level of URE is needed to cushion third-party and common cooperative equities and would greatly limit the potential losses to holders of these instruments. For example, if a funding bank had a loss and there was no URE at the bank to absorb the loss, the association's stock investment in the bank would be the first line of capital to absorb the loss. The association could be required to recapitalize the bank and the bank could also increase its spread it charges on the direct note to generate additional earnings to replenish its capital. If the funding bank did not have URE as the first line of defense in its capital to protect the association's investment, losses at the bank would negatively impact the association's earnings, which could further impact association patronage distributions to member-borrowers. This same argument is applicable to a member-borrower's investment in an association. Whether or not the capital markets and prospective investors conclude that URE and URE equivalents are a “superior subclass” of CET1 is, in our view, probably not going to confuse investors or make a material difference to them. What is important and clear to investors is that all of the CET1 elements will protect all of the third-party equities and sub debt issued by a System bank or association. 40 Part of that message was embodied in the creation of the Farm Credit System Insurance Corporation (FCSIC) and the Insurance Fund, but the Insurance Fund primarily protects System-wide debtholders. The System also asserted that if FCA is determined to require a minimum URE standard, then it should be based on risk-adjusted assets, which is consistent with FCA's current regulatory requirements. The URE requirement would not undermine the System's ability to manage its capital sources as this requirement is only applicable to the tier 1 leverage ratio. We also believe that the 1.5-percent URE requirement should be based on total assets rather than risk-adjusted assets, as System commenters recommended. We believe this requirement is simple, transparent, easy to understand, and reflects the true underlying risk inherent in each System institution. A URE minimum based on risk-adjusted assets benefits institutions with favorable risk weights, and this may not be sufficient to protect System borrowers against a systemic event. We note that over half of the System's capital consists of URE and URE equivalents, with all System institutions easily meeting the required 1.5 percent. As to the System's assertion that too much URE undermines the user-control and user-ownership principles, we disagree. Section 1.1(b) of the Act encourages farmer and rancher-borrowers to participate in the management, control, and ownership of a System institution, and the URE requirement does not undermine this section of the Act. All farmer and rancher-borrowers are allowed one vote, regardless of the amount of their investment in their System association. Moreover, the URE requirement can be fully met with nonqualified allocated surplus and stock, which supports the cooperative principle of user-ownership. The System has asserted that the FCA has not provided reasonable facts, data analysis of loss experience, or empirical evidence to justify a 5-percent minimum leverage ratio. Much of the data the Basel Committee studied in its formulation of the Basel III framework was from the recent financial crisis. For similar data on the System, the FCA would have to go back to the 1980s, when the weakened agricultural economy in combination with the System's interest-rate model at the time resulted in borrower flight, significant losses of System capital, and eventually a Federal bailout. The scarcity and age of most of the relevant data make it of only limited use to us in formulating a leverage ratio, and both the System and financial world have changed radically since the 1980s. Another approach would be to wait until after the next crisis in the System, study the data, and formulate a new leverage ratio based on lessons learned. However, leaving the tier 1 leverage ratio out of our tier 1/tier 2 capital framework would make our capital rule far less comparable to Basel III and the U.S. rule than would a higher minimum leverage ratio. Because of the scarcity of useful data at this time, the FCA has decided not to do a study to “demonstrate and quantify” that a 5-percent minimum leverage ratio is appropriate. However, the FCA does find considerable merit in the System's suggestion to replace the 5 percent minimum leverage ratio with a 4-percent minimum leverage ratio and a 1 percent leverage buffer, and we have revised the final rule to incorporate this suggestion. A 4-percent minimum tier 1 leverage ratio with a 1-percent tier 1 buffer will give additional flexibility to System institutions to make capital distributions and discretionary bonus payments (albeit on a more restricted basis), will appropriately address the System's concerns about a higher minimum leverage ratio giving an unwarranted negative impression about System operations to the capital markets, and will assure the FCA that System institutions will continue to hold healthy amounts of capital against all institution risks. 7. Safe Harbor Requirement The System Comment Letter states the System “respect[s] in principle” the need for restrictions on capital distributions but objects to the proposed safe harbor as follows: • Limiting capital distributions to the past year's net retained income and not allowing for any reductions in CET1 from the prior year-end makes management of regulatory capital “exceedingly challenging and inflexible” and provides no reasonable room to do so without seeking FCA prior approval. • The safe harbor is far more restrictive than foreign cooperative bank regulators' safe harbor, allowing a reduction in CET1 of up to 2 percent without prior approval, and U.S. law that allows capital distributions equal to current year's earnings plus the retained net income for the prior 2 years. • The 30-day approval process is burdensome and unworkable and should be streamlined for institutions with high FIRS ratings, with FCA granting approvals in as short a time as one day. In practice, System institutions rarely pay dividends on preferred stock, make cash patronage payments, redeem or revolve equities that exceed their prior 12 months' net earnings. Associations generally pay out less than 50 percent of earnings, and on [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2016-12072. Public record. Not legal advice.